Will the UK lose its economic power? 15 Jul 2016 14:07 Piia-Noora Kauppi Results of the UK’s EU referendum have sparked confusion and political storms inside and outside the UK. The consequences of Prime Minister Cameron’s gamble should have been foreseeable, considering EU-related votes in other countries: France, Ireland, Denmark, and the Netherlands have already voted against EU integration. As the UK has had an “EU-negative” reputation for decades, the result of the Brexit vote should come as no surprise to anyone following EU politics. The immediate political and economic effects of the referendum were predictable. It was known that Brexit winning would trigger a political crisis affecting all EU citizens one way or another. It was also predicted that the immediate reactions in the European financial markets would be strongly negative before settling into a more permanent state of instability. The duration of this instability mainly depends on how the political crisis is resolved.No surprises for the financial sectorFrom the perspective of the Finnish financial sector, the referendum did not cause any dramatic market changes, although bank share prices have fallen somewhat. While our financial sector is well-prepared against such hazards, the same cannot be said for all of Europe. Many central banks may have to react to the worsening economic prospects by loosening their monetary policies, which will lower interest rates even further. Unusually low interest rates are particularly troublesome to insurers in countries where customers’ savings have fixed interest agreements.The increased uncertainty and slow economic growth are especially concerning for those banks that were in a pinch already before Brexit. One example is the Italian banking sector, where almost every fifth bank loan is a problem loan. Italians have good reason to worry about the decline of bank share prices, as it makes it even more difficult for banks to acquire much-needed additional capital from the markets. The Italian government has already tried to persuade the European Commission and other EU member states to approve the use of public funds for their banks.Capitalising banks with public funds is a prohibited state subsidy and against investor liabilityIt is clear that Brexit doesn’t work as an excuse to break the mutually agreed rules of the EU. Capitalising banks with public funds is a prohibited state subsidy and against the principle of investor liability. Would people trust this principle if it was abandoned at the first sight of trouble? Trust in investor liability is mandatory for risk-based pricing to work.Three weeks after the vote we can now observe that the immediate effects of the vote included no major surprises. Its long-term effects, on the other hand, are difficult if not impossible to predict. Both the political and the economic changes largely depend on how the UK will arrange its relationship with the EU after leaving it.Substantial financial and political changesUK’s withdrawal from the EU can substantially change the EU’s financial markets. Some UK-based market participants will likely move to another member state to retain their position in the internal market. London’s status as an international financial centre will diminish, perhaps considerably so. The position of major financial centres within the banking union, such as Frankfurt and Paris, may consequently become stronger.Brexit may also give non-EU banks an incentive to move their business from London to countries like Ireland, Luxembourg, Germany, or France. Many non-EU banks currently have subsidiaries in London, allowing them to establish branches and operate in the entire EU. This incentive to move depends on what kind of agreement the UK and EU can make on financial services.Moreover, relative power in the European Council and Parliament will shift as the UK will no longer participate in the decision-making process, and member states that support heavy regulation of the internal market will therefore have a stronger voice. From the perspective of Germany, for example, the UK has been a counter-force for France in many political questions.On the other hand, the UK has often emphasised the importance of supervisors’ discretion, the flipside being less predictability from the banks’ point of view. With this emphasis gone, banking regulation may eventually become more predictable, and therefore of higher quality for banks – perhaps paradoxically so.The greatest threat in the upcoming changes lies in the EU’s role in commercial politics and global forums, as the EU may become less attractive to important trading partners like the USA. This can also affect globally operating parts of the financial sector.UK’s withdrawal processThe UK is now expected to announce the start of the withdrawal process according to Article 50 of the Treaty on European Union. This announcement will trigger a complex process where the UK has to negotiate a separate withdrawal agreement and a new framework for cooperation between the UK and the EU. If the agreements aren’t reached in the allotted two years, the UK’s membership will be terminated automatically.Speculations have arisen regarding the idea that the UK never actually initiates the withdrawal process. While this may be possible in the legal sense, it doesn’t sound politically feasible. In any case it is entirely the UK’s decision. Demands to initiate the process swiftly, as expressed by some EU institutions and member states, are no more than political rhetoric fuelled by resentment. What is needed instead is patience, both within the EU and the UK.Many Brexit supporters now seem at a loss as to how to proceed. Some are even baffled by Prime Minister Cameron’s resignation. This easily leads one to think that some opinions on leaving the EU were voiced without a thought of their consequences. But many European pro-EU politicians have reacted indiscriminately too, accusing the Brits of simply voting wrong. This reaction, however, is denial of the deeper implications of the vote’s results.Crises present opportunitiesWithout doubt, the UK’s withdrawal from the EU will create a crisis in Europe. The silver lining is that crises are always opportunities for change – which the EU desperately needs at the moment. If the UK withdraws, it will cause a severe economic shock in the short term and instability in the long term. A large crisis will require large changes.In solving the political crisis, the key issue is how European integration and its next concrete steps are affected by Brexit. A good example is the future of the euro area, which has been debated throughout the spring. Jeroen Dijsselbloem, president of the Eurogroup, recently said that the euro area must continue to integrate, and Brexit only makes it more urgent. According to Dijsselbloem, deeper integration makes the euro area better prepared for economic shocks, and increases financial stability, employment, and growth.Some European think tanks, such as Bruegel, have already shared Dijsselbloem’s thoughts, but opposing views have also been presented. For example, Mark Leonard, director of the European Council on Foreign Relations, stated that the euro area should refrain from large-scale integration projects following Brexit, no matter how tempting they may sound.Then again, the course of integration may generally turn around with time. It is possible that the UK’s withdrawal from EU makes people wonder if the integration has been implemented correctly in the first place. With elections coming up in many countries, politicians have to consider whether the UK’s anti-EU sentiment is contagious. Political decisions will also be made in a more difficult environment overall, as the Brexit-induced financial instability can hinder European employment and growth.